Mortgages began recovering in August following one of the worst months on record. Market stability and successful five- and 10-year Treasury auctions improved the market's tone. In addition, mortgage banker selling was limited to about $1 billion per day on average. All of this contributed to a decline in volatility for the week. From Aug. 1 through Aug 6, spreads on 30-year Fannie Mae 5s and 5.5s tightened 23 to 25 basis points, and 6s moved in 29 basis points. Dwarf 4.5s firmed 22 basis points, and 5s were minus 16 basis points. Last week's tightening pretty much wiped out the previous week's widening.

While there was wide support from banks and money managers, JPMorgan Securities says that a good portion of mortgages' strength last week came from fast money accounts. As a result, they believe there is risk to the sector as these players will quickly convert gains into profits. JPMorgan also says liquidity within the mortgage sector remains poor.

This week will test the market's resolve as there are a number of key economic reports, as well as Tuesday's FOMC meeting.

Mortgage applications hold surprisingly firm

For the week ending Aug. 1, mortgage applications held up surprisingly well considering the back up in rates. According to the Mortgage Bankers Association (MBA), the Purchase Index rose 7% to 456 while the Refi Index declined less than 3% to 4048. Jay Brinkmann, the MBA's vice president of research and economics, said, "The relatively modest drop in refinancing activity, despite a rather sharp increase in interest rates, indicates some borrowers decided this might be their last chance to refinance before rates went up further."

As a percentage of total mortgage activity, refinancings were 58.3%, down from 60.4% in the previous report. Meanwhile, the ARM share of activity rose to 21.7% from 20.6%.

Freddie Mac reported a 20 basis point increase in fixed-rate mortgage rates for the week ending Aug. 8. The 30-year fixed mortgage rate rose to 6.34% and the 15-year fixed increased to 5.66%. The one-year ARM rate reported in at 3.80% versus 3.68%, a rather large rise compared to recent weeks. Analysts are expecting the Refi Index to drop to the 3000 to 3500 area over the next few reports due to the dramatic gains in mortgage rates.

Fannie Mae prepays faster than expected

July speeds came in faster than consensus predicted, including seasoned vintages. For example, 2002 5.5s were anticipated to prepay at 54% CPR, a 27% increase from July; however, the coupon prepaid at 61% CPR for a 45% gain. Speeds were about 5% to 6% CPR faster than anticipated for 5.5s through 6.5s. Meanwhile, 7% vintages generally prepaid 1% to 2% CPR slower than predicted.

In comments from JPMorgan, analysts note that July's report reflected an MBA Refi Index of over 9000. Paydowns came in at nearly $200 billion and is the highest on record. The effect, says JPMorgan, is that the 30-year agency MBS market declined by more than $30 billion as paydowns exceeded supply. In addition, the amount of outstanding agency fixed-rate MBS declined by about $14 billion.

Ginnie Mae speeds were generally in line with consensus expectations. Of note, however, is that speed increases were less than conventionals. According to Citigroup, Ginnie Mae speeds on aggregate prepaid at approximately 7% CPR versus 20% CPR for conventionals. Ginnie Maes are anticipated to report lower percentage declines in the upcoming reports based on the performance of the MBA's Government Refi Index, which has reported smaller decreases or larger increases over the past few weeks.

Prepayment outlook

Looking ahead, mortgage rates are between 120 and 130 basis points higher compared to the lows seen in mid-June, says Citigroup. At this time, just 20% of the mortgage universe is refinanceable, down from 30% at the end of July, and over 90% in early-mid June, Citigroup comments. The firm expects this will be reflected beginning in the August report with a decline in prepayment speeds of around 15% in aggregate, followed by a similar decline in September.


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